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My Wife Gave Me a Three-Bagger

Don't write off the empty store. And listen to your wife.

Opening apologiesSee if you can tell what kind of college I attended by gauging the defensiveness in this opening paragraph. (If you guessed Granola and Leghair U., congrats.) Without getting into a whole big thing about gender roles, let's just say that my wife goes to the mall more than I do. It may not be a girl/boy thing. Malls just give me hives. So, if I almost never go, she can't help but shop more than I do. (Here endeth the gender-issue apology.)

Here's the best part about her trips to the mall. She doesn't just come back with a hernia-inducing load of goods; she comes back with stock ideas. The day before Valentine's Day, she made the best kind of mall trip there is. She returned a few things, and came back with something even better than credit slips: a really good investment idea, the kind of thing that would even turn the heads of the picky investors at Inside Value.

Anyone who's read Lynch on Hanes' L'eggs -- which ended up part of Sara Lee(NYSE:SLE) -- or listened to Bill Mann talk about how he came across RedEnvelope(NASDAQ:REDE) is familiar with the usual wife's tale: Stodgy investor husband is convinced by enthusiastic wife that product and/or company has great potential. Slow-witted husband finally gets it through his thick head that he should listen to wife, who is an expert on the whole shopping thing. Company does great: couple makes a killing. Moral? That teeming store or great customer-service experience is often a good place to start hunting for investments.

More than meets the eye?But my case went a bit differently. My wife passed this store in the mall and noticed that it was relatively empty. She came home with the morbid fascination of the car-wreck rubbernecker. If the place was empty, she wondered, what do the revenues and earnings look like? Then she did something that should make any Fool proud. She headed straight to the Internet to look up the firm's latest numbers. Better yet, she started plugging them into our Inside Value discounted cash flow calculator. (Excuse me while I pause to wipe a tear from my eye.)

She still had to convince the cranky husband to take a look. The conversation went a little like this.

Darling Wife: Hey, have you looked at Brand X? It looks like a three-bagger.

DW: Yeah, it looks that way, but check out the growth numbers. They're solid, and analysts expect them to get better.

SSWH: Sure, if you trust the analysts' estimates. What if they're wrong?

DW: I already adjusted for that. Even if you assume really low growth, it's still a double.

SSWH: What's your discount rate?

DW: 12%.

At this point, the greed was enough to tear me away from my muy important weekend work -- probably reading Dave Barry's blog or leveling my "War-Crack" elf.

The wife gets value feverShe wasn't kidding. This did look like a real bargain, both on the surface and after further digging. So, I'm going to share some of the story with you. But I'm not going to tell you which company this is. (That Brand X thing was a tip-off, no?)

There are some things that should remain confidential in the husband-wife relationship, and if you ask me, a Saturday afternoon three-bagger is one of those things.

Still, I'm going to tell you about the company because if you want to learn how to find good value stocks, the process is what's important. The figures will be modified, or stated vaguely, so that you Sneaky Petes (or Paulines) won't be able to identify Brand X very easily, if at all. The point here isn't to give you a solid stock tip -- you can try the newsletter for some of those. Instead, Brand X provides a couple of good lessons for any budding stock cheapskate.

The first is this: Stock ideas can pop up where you least expect them. Don't just run the numbers on the hot new item or the latest crash-and-burn. Take a look at the hard-to-notice wallflowers as well. Sometimes, they grow into the greatest beauties of all.

Of course, ideas are just the beginning. You need to follow up your leads with some more number crunching and then, ultimately, you need to make a judgment call. Why is the market ignoring the stock? Are the reasons valid? There's "art" in even the most mathematically rigorous valuation strategies. But by being a value-oriented stock picker, you can significantly reduce your risks. More on that below.

The final lesson? Listen to your wife, man. It's not just good PR. If she's anything like mine, she may be a lot more clever than you are.

What's all the excitement?If you screen for value stocks using typical benchmarks like low price-to-earnings (P/E) or low price-to-book ratios, Brand X would not have turned up in your net. It's not an obvious value play. I think it's safe to say that it wouldn't be the kind of company that would necessarily appeal to our own value guru, Philip Durell, for a couple of reasons. To begin with, the company is small, still under $1 billion in market cap. Moreover, with a P/E ratio in the mid-20s, it looks more richly priced than many of its retail peers, excepting supergrowers such as American Eagle Outfitters(NASDAQ:AEOS) or recently redeemed Abercrombie & Fitch(NYSE:ANF) -- a 42% gainer, by the way, since I recommended it for Halloween. It also trades at roughly three times book value, ahead of the industry benchmark.

So what in the heck makes the wife and me think Brand X is such a steal?

Let's start with the cash flow. By my calculations -- based, I should note, on partial numbers, since the latest quarterlies haven't been filed with the SEC -- the firm trades at an enterprise value-to-free cash flow (EV/FCF) multiple of near 10, if not less. By the way, that's even after you count lease obligations as debt. To put it another way, at the market's current valuation, the business at Brand X churns up excess cash at 10% or better per year. That's cash that could be used for stock buybacks, smart growth, debt repayment, or even a dividend.

By now you should be slavering, skeptical, or both. If it's both, congrats. It's always good to combine some fear with your greed. The skeptics out there should be wondering, "with cash generation like that, how can this still go unnoticed?" I believe the answer is in the margins.

The wet blanketFrankly, they just don't look so hot. Mid-single-digit net margins are significantly lower than industry leaders, and even lower than some struggling peers. Over the past year, margins have been closer to J. Jill(NASDAQ:JILL) territory, which isn't the best place to be. Also, sales over the past decade look like a bit of a roller-coaster ride.

"Ah ha!" You're thinking. "I won't invest in retail, especially in a firm with lumpy sales and subpar margins!" That's fine. I respect that point of view. And I'm guessing most of the Street shares your opinion. But here's where we get to the artsy part of valuing a company. Here's where value investors should be looking at things differently. In fact, the wife and I are willing to buy this company precisely because those sales look lumpy, and because those margins are low. Why?

The stylish retortBecause there's room for improvement, and better yet, Brand X's management has been delivering improvements, consistently, over the past few years. Overall revenues as well as comps have booked steady gains over the past eight quarters, though they have not been flashy enough to draw much attention from the Street. That's good in our book. Bloated top-line growth attracts the buzzards very quickly, and that usually translates into overpriced stocks.

Things look even better at Brand X the further you read down the operations sheets. Net margins have gotten 6% fatter over the past two years. Operating margins have jumped 9% over the same period. And gross margins have ticked up as well.

There are several reasons for the increased profitability. Brand X has closed underperforming operations and resourced its apparel to cheaper, foreign providers. It's also revamped its distribution network. The payoff here has been much better inventory management and major improvements in the cash conversion cycle.

Finally, it restructured its debt a couple years back, resulting in significant interest savings. End result? Brand X has come off some losses to put in 25% earnings growth recently. (Yes, I'm still being vague. I'm not going to make this easy for you.) A consequence of the increased profitability is that it now has a lot more cash than long-term debt, and should it choose to get rid of the debt, that alone might result in another 15% to 20% boost in earnings. Factor in continuing improvements in operating efficiencies, and you can see why I believe that even modest sales growth will be enough to keep this earnings engine revving. For what it's worth, analysts think earnings per share (EPS) will clip up in the 20% range for the next five years.

What's the price?Of course a "sale" at the mall is no different from a "sale" on a stock. It's not what you get, but the amount you pay, that determines whether you're really getting a bargain. Luckily, at Inside Value, we've got a handy tool that does the heavy math to help us get a handle on prices and payoff. What the discounted cash flow calculator does is provide a thumbnail idea of the present value of a company's future cash flows. (For an in-depth explanation, written by a much smarter Fool than I, click here.)

In other words, given Brand X's cash flow and expected growth rates, what is it worth now? Remember, we have to make some assumptions about that growth, as well as risk, in order to arrive at these values. But when I ran the numbers, I was convinced enough to seal the deal. Step into the dressing room, try these numbers on for size, and see what you think.

High-risk matrixIf you believe Brand X is a fairly risky investment, you may set your discount rate at 15%. If you think it's less risky, you might go with 12%. The next step is to enter growth rates. As I mentioned, analysts are expecting 20% growth for five years from Brand X. Our calculator attempts to look out further than that. So, we need to enter growth rates for the first five years, then the next five, and finally, the terminal rate -- which we usually just peg at the economy's rate of growth, say 3%. So, for example, "20 - 7 - 3" predicts the current price based on 20% growth for five years, 7% for the next five, and 3% after that. Similarly, "7 - 3 - 3" looks for only 7% growth for the first five years, and the terminal rate thereafter.

Growth Rates

Intrinsic Value

Margin of Safety

20 - 7 - 3

$55

66%

15 - 5 - 3

$43

57%

10 - 5 - 3

$36

49%

7 - 3 - 3

$31

39%

3 - 3 - 3

$26

29%

Based on a 15% discount rate and current share price of $18.45. No, that's not the real price. I divided the real price and cash flows by a mystery number to keep Brand X a secret. The margins of safety and potential returns are the same as the real Brand X.

As you can see, my most pessimistic evaluation of the firm's growth (3 - 3 - 3), coupled with the most demanding discount rate (15%), still results in a share price that has a 29% margin of safety.

Medium-risk matrixPersonally, I put my discount rate at 12%, though given Brand X's strong... well, brand, I think 10% might be fair. A 12% rate results in the following value matrix.

Growth Rates

Intrinsic Value

Margin of Safety

20 - 7 - 3

$76

75%

15 - 5 - 3

$59

69%

10 - 5 - 3

$49

62%

7 - 3 - 3

$41

55%

3 - 3 - 3

$34

47%

Based on a 12% discount rate.

My conservative expectations for the company's growth (10 - 5 - 3) peg the current price at a 62% margin of safety. Should it reach what I consider to be its intrinsic value, it would be a 166% gainer. Should it do better than that -- but still worse than what analysts expect -- it would be a triple (thus the three-bagger from the title). Will it get there? Hey, if I knew for sure, I'd already be sipping frozen drinks on a tropical beach somewhere.

Remember, we could be wrong. In fact we expect to be wrong about any number of our assumptions. But there's the beauty of value investing and that margin of safety. If we've screwed up, even significantly, we should see less downside risk. In my book, and my wife's, it would be pure foolishness (with a little f) not to buy a few shares and see.

The Foolish value lineHey, it's been a long column and I didn't even give you the darn stock, so I won't belabor the moral of the story. Being a value investor is about more than screening for low P/Es and other metrics of cheapness. It's about keeping your eyes open for outliers and running their numbers. Don't just use the same valuation benchmarks as everyone else.

Consider the trends that the others haven't noticed. Consider the possibilities of redeeming a brand. Don't be afraid to predict the future. That's the only way you're going to get stocks that the rest of the Street is ignoring. Ultimately, you have to make judgment calls. Just remember your margins of safety. Make sure that you are buying goods that are cheap enough to let you sleep at night, should your predictions not come to pass.

So take a look at the unloved, trust your analysis, and most of all, remember that more brains are better than one. If your spouse isn't interested in digging up and batting around investment ideas, Inside Value has a whole community full of avid cheapskates who will be happy to hear what you think. You can check it out for one month on the house. You won't find out about my afternoon three-bagger, but there are plenty of other solid picks to choose from.

Seth Jayson is happy to have someone else coming up with the stock ideas. His small brain can only handle so much thinkin'. At the time of publication, he had positions in RedEnvelope, Brand X, and a dozen or so retail stocks that he bought in order to throw you Sneaky Petes off the scent. He's that committed to the bit. He has no position in any other company mentioned. View his stock holdings and Fool profile here. Fool rules are here.